Tuesday, January 12, 2010

Rates Strategy: Here Comes The Weatherman

I concluded my last tactical bond market outlook (see Rates Strategy Update: Still long but... dated December 14) with: "For the time being and given that the upward trend in the Bund future remains intact (currently running at around 121.63), I stick with a bond-bullish tactical outlook but see rising risks of a temporary but potentially significant setback on the horizon."In the meantime 10y Bund and UST yields rose by approx. 20 and 30bp, respectively before coming back a bit over the past days.In turn, I believe that the temporary setback I was talking about is behind us and expect yields to retreat again from here onwards and propose a tactical bond-bullish stance.

First, consensus for this year seems to be that there is only one way to go for bond yields during 2010, up. By now, however, this seems to be reflected in positioning. The chart below shows the risk-weighted net positioning by non-commercial accounts in the US 2y, 5y, 10y and 30y futures (I used the pvbp to aggregate the various futures contract and in turn, the positoning should reflect mln USD per basispoint in yield change). While in early December, positioning was neutral (following a long period of a short base), within a matter of only one month, net positions have moved back to a very significant short base. This has come about by a reduction in net longs in 2y and 5y futures and an increase in the shorts in 10y futures. Over the past 3 years only one week at the end of May had a more pronounced short position which was just before the 10y yields hit their intra-year high at the beginning of June.

Positioning in US bond futures are strongly tilted in favour of shorts

Source: CFTC, Research Ahead

Also from a longer term perspective, the current positioning can be considered significant. The chart below shows the history since mid 2002 to cover the last rate hiking cycle/multi-year bond bear market between early 2003 and early 2007. When net shorts were of the magnitude they apparently are today, 10y UST yields tended to top out soon and fall back significantly even if only on a temporary basis. In turn, at present positioning gives a strong signal against the bond-bearish consensus!

The current level of short positions was historically soon followed by a drop in yields

Source: CFTC, Research Ahead

Technically, bond markets look a bit more vulnerable given that the previous bullish trends which guided trading since early June have been broken. However, markets look oversold and stochastics have been turning higher from a low level which is usually also seen as a (temporary) buying signal. The chart below highlights this situation for the Bund future.

From a cross-market perspective, bunds and USTs were trading at expensive levels in early December vs. equities and commodities. However, in the meantime, the rise in yields has taken bonds back to fair-value. For 10y Bund yields, the error-term of the regression is approx. 0bp after having been above 20bp (i.e. larger than 1.5 standard deviation) in December (see chart below).

10y Bund yields vs. EStoxx and the CRB-index: back at fair-value

Source: Research Ahead

Fundamentally, I think that inflation worries, especially in the US where break-evens have increased significantly over the past weeks to almost 2.50% in 10y TIIs, are overdone given the amount of spare capacity and given that the broad-based credit aggregates are shrinking. Furthermore, the recovery hopes might get another temporary dampener in the weeks ahead. The reason here might well be that the cold weather and the associated heavy snow falls in large parts of the Northern Hemisphere act as a strong headwind for economic activity. The impact of the weather on short-term economic developments is frequently underestimated. There are various ways the weather affects the economy (for example people tend to go out less when the weather is poor and in turn consumption suffers; also when there are snow storms it affects the production by corporates etc.). The weather is a key reason for the seasonal variation in the economy. However, seasonal adjustments only take care of the average seasonal weather. Unfortunately, the weather is rarely average! In order to highlight the importance of the weather on short-term economic and market developments I constructed a small trading rule. In short, this model goes short bonds (here expressed via a payer position in 10y USD swap rates) whenever the weather is milder than is usually the case, i.e. warmer in winter and colder in summer. It enters a swap receiver position whenever the weather is more pronounced than is usually the case, i.e. colder in the winter and warmer in the summer.[I use the monthly data for population weighted heating degree days and cooling degree days for the US (they intend to measure the average energy needs for heating/cooling purposes and an overall number as well as the deviation from the "norm" is published). If the HDD days during winter are larger than the norm, then the winter is colder than is usually the case and accordingly a receiving position is initiated (and vice versa). Given that the weather for a specific month is only known at the end of that month, the position is opened at the start of the next month. This means that a colder-than-usual December triggers a long/receiving position for January. Given that most economic data is also released with a delay, this should fit the market impact.]The chart below shows the development of the 10y USD swap rate together with the cumulative p&l of this simple trading rule. Over the past 11 years this trading rule shows a cumulative profit of more than 1000bp. This highlights that the weather indeed has a significant impact on short-term macro-economic and market developments.

Profitable trading rule suggests that the weather has indeed a significant impact on short-term market behaviour

Source: Research Ahead

In the US (but also in Europe), November was much warmer than is usually the case. However, December has been much colder. In turn, this rule would have suggested a short bond/swap payer position for December but is now proposing a long bond/swap receiver position for January).

Overall, I think that we should see yields falling back again in the weeks ahead especially due to a pronounced bond-bearish consensus/short positioning but also because the stronger-than-usual winter in the Northern Hemisphere might temporarily act as a headwind for the Western economies. In turn, I continue to propose tactic long positions in both 10y Bunds and 10y UST.

Hi Mark,thanks for your comment. I will respond to these questions over the next days.overall, I maintain my view that corporate bonds of relatively sound countries (i.e. Germany/Netherlands/France etc.) should be overweight vs. weak sovereigns (Portugal, Greece, Spain and also Ireland). Rates should remain at historic low levels for a prolonged period of time which forces investors into pick-up products and will see a continuation of demand for corporates. High-grade corporates should fare well also over the current year vs. speculative grade (still challenging economic environment) and sovereigns (ongoing high supply, lower liquidity support, rising risk of funding crisis in some countries). Greece is a tricky situation. Ultimately, if the market forces it, then there will be EU/IMF-type bail-out with (hopefully) painful strings attached, helping GGBs. But that is not likely in the near-term and the negative news-flow should continue a bit further rendering investments risky.

Explanation: Degree day is a quantitative index demonstrated to reflect demand for energy to heat or cool houses and businesses. This index is derived from daily temperature observations at nearly 200 major weather stations in the contiguous United States. The "heating year" during which heating degree days are accumulated extends from July 1st to June 30th and the "cooling year" during which cooling degree data are accumulated extends from January 1st to December 31st. A mean daily temperature (average of the daily maximum and minimum temperatures) of 65°F is the base for both heating and cooling degree day computations. Heating degree days are summations of negative differences between the mean daily temperature and the 65°F baseDegree days are estimated for State climate divisions and then population weighted to more accurately reflect temperature-related energy consumption at the State, regional, and national levels.

As a result, they should give an accurate measure of the average (population weighted) temperature prevailing in the US. Given that it is population weighted it should be also accurate for the economy.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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